Promotions and the Bottom Line

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For most firms, new products are growth engines, despite the fact that by some accounts as many as 60% of them fail. And even when a novel product or feature is a hit with consumers, the benefits accruing to the innovator may quickly evaporate as competitors rush to emulate. So most firms combine product innovation with promotional incentives to maintain consumer interest and stimulate sales. But what is known about their actual impact on corporate financial well-being?

Typically, marketing managers measure new-product success by assessing whether the product or new feature has achieved its objectives. Prone to self-reporting bias, such analyses are of questionable use in justifying product-innovation investments to CEOs and CFOs, because they lack objective measures of short- and long-term financial performance and firm-value effects.

However, a recent econometric study of the automobile industry addresses these shortcomings by measuring the short- and long-term impact of new-product introductions and promotions on top-line (revenues) and bottom-line (income/ profit) financial performance and stock-market value. Issued in February 2003 as a working paper of Dartmouth's Tuck School of Business, the study is “The Long-Term Impact of New-Product Introductions and Promotions on Financial Performance and Firm Value,” written by Koen H. Pauwels, assistant professor of business administration at the Tuck School of Business at Dart-mouth; Jorge Silva-Risso, executive director of marketing at J.D. Power and Associates and a visiting assistant professor at the Anderson Graduate School of Management, University of California, Los Angeles; Shuba Srinivasan, assistant professor of marketing at the A. Gary Anderson Graduate School of Management at the University of California, Riverside; and Dominique M. Hanssens, Bud Knapp Professor of Management at the Anderson Graduate School of Management, UCLA.

The researchers gathered data from 1996 to 2001 relating to the big six automobile manufacturers (DaimlerChrysler, Ford, General Motors, Honda, Nissan and Toyota) and six car categories such as SUV, minivan and premium compact. They used a total of 41 brands as the unit of analysis for marketing variables (for example, Ford's Lincoln and Toyota's Lexus brands).

Study data comprised sales-transaction information from J.D. Power and Associates' marketing database, JDPA's expert opinions on the technological newness of new vehicles and vehicle updates for each brand, firm-value data from market capitalization and daily market indices (Standard & Poor's 500) of the New York Stock Exchange (obtained from the Center for Research in Security Prices database), firm-specific information and quarterly accounting information (for example, book value, revenues and net income) from Standard and Poor's 1999 Compustat database, and analysts' earnings forecasts for the six automobile manufacturers from the I/B/E/S database.

According to the analysis, new-product introductions exert positive performance and stock-market value effects, which grow over time (that is, the long-term impact on firm value is greater than the short-term impact). Moreover, these company-level benefits appear to be of long duration.

As one might expect, major innovations have a stronger impact on revenue than minor ones, reflecting consumer enthusiasm for breakthrough car models. However, intermediate innovation levels (such as partial sheet-metal changes) have less impact on income than mere styling changes. These results are consistent with previous reports of negative financial returns attributed to bringing new car models to market, demonstrating how crucial innovation costs are in this particular industry. “Overall, however, new-product introductions seem to set a virtuous cycle in motion,” says Pauwels. “Consumers and investors respond favorably, enabling companies to fund additional innovation.”

In contrast, sales promotions (such as rebates) invoke what can be viewed as an overall vicious cycle. That is, such incentives exert a positive short- and long-term impact on top-line performance and yield immediate increases in bottom-line performance and firm value. However, they exert a negative long-term impact on bottom-line performance and thereby on company value. “Clearly, promotions stimulate consumer demand only temporarily, so companies must repeat them to maintain revenues,” says Srinivasan. “Yet all the while, profit margins are being eroded — hurting income and firm value in the long run.”

Evidence indicates that new product introductions appear to correlate with the use of fewer promotions, suggesting that a policy of aggressive product innovation acts as an antidote for excessive reliance on consumer incentives.

The authors point out a few limitations to the study: Data cover only a fraction of one industry's history, and the study does not address the relative innovativeness of competitors' offerings. Nor does it investigate consumer-acceptance ratings prior to a product launch (which might enable researchers to predict the performance impact of a specific innovation).

What does this work imply for product-innovation strategy within both the automobile business and similar product-driven industries? “Executives should focus on new-product introductions and resist relying on promotions in their efforts to boost long-term market capitalization of their companies,” says Silva-Risso. “Though consumer incentives may provide a short-term performance lift or prevent severe sales erosion while product-innovation projects are in the pipeline, they don't reliably bolster long-term corporate income.”

As might be intuited, investors typically view product introduction favorably in the short run, but the ultimate commercial success of a new product determines its long-run impact on a firm's market value. Moreover, while radical innovations offer potentially the greatest benefit, managers don't always have to incur the high development and launch costs associated with major product innovations. Indeed, the U-shaped relationship between degree of innovativeness and long-term firm valuation suggests that companies can benefit from “pulsing” innovations as well — that is, following-up new brand entries with minor improvements instead of engaging in continuous, intermediate-level innovation. Such an incremental approach has been used with success by Ford Motor Co., which returned its Lincoln brand to profitability by using relatively minor updates that entailed lower development costs, instead of launching a new, global luxury brand.

“In the auto industry, new-product introductions generate tens or hundreds of millions of dollars' worth of long-term stock-market value. At the same time, rebates may subtract tens or hundreds of millions,” says Hanssens. “Their widespread and simultaneous use may help explain the long-term swings in stock prices that sometimes plague this particular industry's players.”

For further information about this research, contact the authors at koen.h. pauwels@dartmouth.edu, jsilva@anderson.ucla.edu, shuba.srinivasan@ucr.edu and dominique.hanssens@anderson.ucla.edu.

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